How Far Can China's Monetary Tightening Go?

With Europe embroiled in the sovereign debt crisis and the US economy not recovering as quickly or as strongly as hoped, investors are now turning their attention to a slowdown in Chinese economic activity.

Apartments in China
Apartments in China

On Tuesday, the Chinese central bank raised the reserve ratio requirement for banks for the ninth time since last October after data showed inflation rising to its highest level in almost three years.

On Monday, China’s central bank published figures which showed broad money supply (M2) grew by a comparatively anemic 15.1 percent in May compared to a year earlier, the slowest rate of growth in 30 months.

Only $85.1 billion of new yuan loans were created in the month, much less than the $95.1 billion that was expected by analysts.

But that is a good thing, according to Donna Kwok, Greater China economist at HSBC, as the slowdown in the Chinese economy is necessary to avoid something far worse.

Beijing had been pursuing a policy of monetary tightening for much of the last year with varying degrees of success and the Chinese central bank had been concerned about the availability of easy credit for a long time, Kwok said.

“It’s difficult in that much of that has been credit driven as banks have had a mandate to lend throughout 2009 and most of 2010, but the central bank has been trying to cool off credit growth since last October, and the mission's beginning to have some success,” she said.

However, Peter Dixon, economist at Commerzbank, issued a word of caution that the central bank could go too far in its efforts to cool China’s economy.

“If the Chinese authorities reduce growth by too much then that means less funds to buy US treasuries which will push global interest rates up,” Dixon told

“If the Chinese economy crashes it will have an impact on the wider region, which would have implications for the rest of the world,” he added.

Reading the Central Bank's Actions

Those implications may not be direct, Dixon said, given the main impact of a Chinese economic crash would on its ability to “suck in more imports”.

“Investors are paying a lot of attention to China's cool-down and central bank policy at the moment, given the critical support the country offered to the Asian and the wider global recovery throughout last year,” Kwok said.

Dixon added that while many investors were watching Chinese monetary policy very closely “it's not quite as easy to read as the Fed.”

“The way the Fed used to come at policy was it would act and then we would learn about it once it had acted,” he said.

“In a similar way the Chinese now acts and we learn about it after. We certainly don’t have the same amount of information flow. We have to look closely at what they are doing and what it means for the global economy,” Dixon said.

But as Tuesday’s Chinese inflation figures revealed, the central bank still has more work to do to get the economy under control.

China's inflation accelerated in May to a 34-month high of 5.5 percent in spite of other indicators suggesting economic growth was slowing down.

This seems to support Kwok's argument that the central bank has not yet won the battle with inflation.

“We need a few more months of monetary tightening and slower credit growth numbers before we can be sure inflationary pressures have cooled sufficiently," she said.

“What we are saying is that even though growth has slowed, this is a cool down, not a melt-down. China is slowing towards a growth rate that is more sustainable in the long-run. If China's economy is to be re-balanced, double digit credit fuelled growth rates cannot be sustained in the long run,” Kwok added.

Meanwhile, for those taking a longer term view Dixon suggested although China may become a big beast in the global economy it won’t have it all its own way.

“I think it's important we don’t extrapolate recent trends too far into the future,” he said.

“There’s a lot of debate as to when the Chinese will overtake the US, in my view its closer to 20 years than 10, but everyone accepts that is inevitable given the size of the Chinese population," he added.

"What’s not clear is beyond that. Demographically the Chinese are not quite as powerful as it was once thought they would be partly because of their 'one child' policy, which may act as a constraint on economic growth in the future as well as a constraint on the population, so we may be looking at other growth centers like India,” Dixon said.

While no one doubts the important role China already plays, and will continue to play, in the Asian economy and by definition the wider global economy, it won’t necessarily have “the same unique position at the top of the economic tree as other countries have had in the past,” he added.

Dixon believes China will be matched by India in the long term and that the US will remain an important player in the global economy.

“The global economy of the future is likely to be one of trading blocks,” he said.